IRS Tips vs. Service Charges in Restaurants

If you own a restaurant, you’ll want to pay attention to a big change to tax rules that are now in effect. This is especially if your business has a policy of adding automatic tips to the tabs of large parties or for other special circumstances (curbside delivery, check splitting, etc.).

In January, the Internal Revenue Service clarified its definition of "service charge" - to include those automatic gratuities. That means these kinds of tips are now treated as regular wages, subject to payroll tax withholding - instead of standard tips, which restaurants leave up to the employees to report as income.

So accordingly, service charges must be included in the calculation of hourly employees' regular rate of pay which could affect overtime calculations. That also means hourly pay rates could vary day to day depending on how many large parties are served. The IRS ruling on automatic gratuities was actually issued in June 2013. However the agency delayed implementation until January 2014 to give restaurants and other affected businesses time to comply.

When is a Payment Regarded as a Tip or a Service Charge?

The IRS established the following rules that make a payment a tip:

• Payment must be made free from compulsion.
• The customer has the unrestricted right to determine the amount.
• Payment should not be subject to negotiation or dictated by employer policy.
• Generally, the customer has the right to determine who receives payment.

Therefore, according to the updated rule, automatically added tips are service charges because they aren't voluntary. In a question-and-answer section of the ruling, the IRS provided an example of a restaurant suggesting different tip amounts, and said that practice isn't subject to federal withholding because the customer is still free to choose whether and how much to tip.